Trading in the Fixed Income Market

Part 1: Buying Bonds

The fixed income market (which is simply a different name for the bond market) is composed of securities that represent portions of loans made by investors to borrowers. The borrowers that issue the bonds may be governments, government agencies, states, municipalities, or corporations. The lenders who buy the bonds can be banks, insurance companies, pension plans, or individuals. The majority of these bonds are at a stated fixed interest rate (also known as the coupon) and for a fixed term. The borrower pays interest periodically, usually either annually or semiannually, to the bondholder until the loan comes due, or matures, and the principal is repaid by the borrower.

Most often sold in $1,000 denominations, bonds are typically identified by quoting the interest rate they pay, the issuing entity, and the maturity date. For example, a bond might be described in this manner: the 8% IBM of January 20th 2010; or perhaps the 6.5% Treasury of April 1st 2020. The bonds, which act as evidence of the indebtedness, trade freely in the market and may change hands numerous times between their original issuance and maturity dates. Each time they change hands, they may do so at a different price.

Bond prices are quoted in points, where each point is equivalent to $10. If a bond is quoted at “85”, for instance, then its cost would by $850 (85 points x $10 = $850). Likewise, a price of 120 represents a cost of $1,200. Partial points are quoted in increments of 1/8th, 1/10th, or 1/32nd of a point depending upon the market conventions for that particular type of bond.

While many factors may contribute to the value which the market places on a particular bond, its market value rises and falls primarily in response to two factors: 1) the relationship between current interest rates and the bond’s coupon (as stated previously, the bond’s coupon is its stated interest rate). For example, a bond which pays 9% per year would be a very attractive investment if new bonds being issued are only paying 5.5% because rates have declined. Investors would undoubtedly be willing to pay a premium -- a price above a bond’s face, or par, value -- to purchase this bond because it pays an above-market interest rate. Its price would rise until it offered an overall return (a yield to maturity, or YTM) which was competitive with the new bonds.

On the other hand, if interest rates have risen and new bonds being issued are paying 13.5%, then the attractiveness and value of the 9% bond will drop. Investors would not be willing to pay full value for this bond. Its value will decline until its overall return becomes competitive with new bonds. Bond prices change almost on a minute-by-minute basis as market interest rates change.

2) The second factor which affects a bond’s market value is the probability of whether the borrower will be able to meet its interest and principal payments in full and on time. Bonds which are backed by financially strong issuers are more desirable than bonds backed by issuers whose credit may be suspect. As the issuer’s credit quality changes, so does the value of the bonds which it issues.

Part 2 of this series will examine bond yields and interest.